The subprime financial crisis: Reflections from a post-

Keynesian viewpointMarc Lavoie

University of Ottawa

Outline

• Some historical background

• A change of paradigm, in policy, in theory?

• Presuppositions in economic analysis

• Financialization

• Securitization

• A Minsky crisis? A new Great Depression?

Some recent historical background

A couple of years ago hardly any economist knew about these terms

• ABS, MBS, RMBS, CMBS, ABCP, CDO, CDO2, CMO, CLO, CDS, EDS, SPE, SPV, SIV

• asset-backed securities, mortgage-backed securities, residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed commercial paper, collaterized debt obligation, collaterized debt obligation squared, collaterized mortgage obligation, collaterized loan obligation, credit default swaps, equity default swaps, special purpose entity, special purpose vehicle, structured investment vehicle

Some warning signs

• 2005: High share of new mortgage loans that were subprime;

• 2006: Risky mortgage formula (interest only, 2/28, negative amortization)

• Mid 2006: US Real estate prices stop rising• Early 2007: the cost of insuring BBB mortgage-

backed securities against default losses rose briskly (MBX indices take a plunge)

Flow of US subprime mortgages

The real estate bubble bursts, first in the US (mid 2006) and then in the UK

U.S. AND U.K. HOME PRICES

-20

-15

-10

-5

0

5

10

15

20

25

30

2000 2001 2002 2003 2004 2005 2006 2007 2008

U.K. Nominal Average National Home Price

U.S. National Home Price Index S&P/Case Shiller

Y/Y percent change

Source: Moody's Economy, Nationwide Building Society

Falling values of MBX, the reverse of the

cost of default insurance on MBS

The beginning of the end, all related to MBS

• August 2007: – confidence crisis: Near gridlock on the European interbank market;

• September 2007: – Bank run on Northern Rock; – AAA and BBB MBX indices plunge;

• March 2008: – Bear Stearns collapses and is bailed out;

• September 2008: – Freddie Mac, Fanny Mae; – Wall Street banks collapse and are bailed out, except for Lehman

brothers; – stock markets plunge;– Big commercial banks collapse in the US and Europe; – AIG is nationalized; – The entire Islandic banking system is nationalized.

Asset-backed short-term paper market in Canada shuts down in August 2007

-10

-8

-6

-4

-2

0

2

4

6

8

I II III IV I II III IV I II III IV I II III IV I II III IV

Other short-term paper liabilities, Issuers of asset-backed securities

billions of dollars

2004 2008 2007 2006 2005

Stock markets finally plunge for good in September 2008

U.S. AND CANADIAN STOCK MARKETS - 2008

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

Dec-26Oct-31Sep-5Jul-11May-16Mar-21Jan-25

8,000

9,000

10,000

11,000

12,000

13,000

14,000

15,000

16,000

S&P 500 (right)

S&P TSX (left)

Index, weekly closing price Index, weekly closing price

Source: Bloomberg

Bear Stearns TakeoverMar. 17

Lehman Bros. CollapseSep. 16

A change of policy paradigm

A second Keynesian pragmatic revolution

• In contrast to previous financial crises, the IMF advocates low interest rates and government stimulus packages with budget deficits;

• G20 leaders move away from unfettered markets and uncontrolled capitalism;

• Gordon Brown (UK): “The Washington consensus is out”;

• Financial Times: “The credit crunch has destroyed faith in the free market ideology”.

Two opposite views back in favour in the media

• Neo-Austrian theory (Hayek, von Mises) at the forefront of the second counter-revolution;

• Post-Keynesian monetary theory (Galbraith, Minsky) at the forefront of the second Keynesian revolution;

The neo-Austrian view (not mine!) of the crisis in a nutshell

• The US government (CRA) forced banks to grant subprime loans.

• The Fed set short-term rates at too low a level (from 2002 to 2004).

• The Chinese rigged the exchange rate and flooded long-term bond markets, also leading to overly low long-term rates.

• There would be no crises if government was small and interest rates were always set at their natural levels.

The post-Keynesian view of the crisis in a nutshell

• The current regime of accumulation (based on low real wages and consumer debt) was unsustainable.

• Financial crises are an endogenous feature of unregulated capitalism.

• Western economies have moved towards a financialization process over the last decades, with deregulation of the regulated financial system and growth of the unregulated financial system.

• As a result, financial crises are more frequent and more severe.

Presuppositions in economics

Macro-economics

Heterodox authors

Neoclassical school

Marxists CambridgeKeynesians

OldKeynesians

Monetarists

New Keynesians

New Classicals

RadicalsFrench

RegulationSchool

Post-Keynesians

KEYNES

Mainstream economics

New Neoclassical Synthesis

New Consensus(DSGE)

New Keynesians New ClassicalsNeo-Austrians

(neo-Wicksellians)

Variety of Heterodox Keynesians

Heterodox Keynesians

Marxist Keynesians

French Regulation School

French Convention School

Cambridge Keynesians

Fundamentalist Keynesians

Institutionalist Keynesians

Paradigm

Presupposition PK and Heterodox schools

Mainstream or Neoclassical

schools

Epistemology Realism Instrumentalism

Rationality Reasonable rationality

Model-consistent rationality

Ontology/Method Holism, organicism

Individualism, atomicism

Economic core Production, abundance

Allocation, scarcity

Political core Regulated markets Unfettered markets

Presuppositions of the heterodox programme vs those of the mainstream

Example of instrumentalism

• The use of the parameters of the Cobb-Douglas function to estimate the production elasticities when we know that these parameters only estimate the shares of wages and profits.

• The use of the Gaussian copula function to estimate default correlation and thus the prices of CDO – the synthetic MBS. These were based on recent MBX prices, the prices of credit default swaps on MBS, on the assumption that markets price risk correctly, instead of being based on the default records of actual borrowers.

• For instrumentalists, “It is better to be precisely wrong than roughly right”.

Model-consistent vs reasonable rationality

• Model-consistent, rational, expectations– Agents know all contingencies– Agents all assume the same model– Agents can do the most complicated computations

• vs• Reasonable rationality

– Ecological rationality: simple rules– Reaction to a discrepancy wrt some norm– Traders, chartists, trends

Holism: Some crisis-related macro paradoxes

Paradox of thrift (Keynes) Higher saving rates lead to reduced output

Paradox of costs (Kalecki) Higher real wages lead to higher profit rates

Paradox of public deficits (Kalecki) Government deficits raise private profits

Paradox of debt (Steindl) Efforts to de-leverage might lead to higher leverage ratios

Paradox of tranquillity (Minsky) Stability is destabilizing

Paradox of liquidity (Nesvetailova) Efforts to become more liquid transform liquid assets into illiquid ones

Paradox of risk (Wojnilower) The possibility of individual risk cover leads to more risk overall

Tranquillity, liquidity, risk

• As time goes on, the risk level as computed by engineering models of finance (Value at Risk), appears to get smaller because the last recession is just one remote observation among a series of more recent successful years.

• A financial innovation that leads to both new ways to finance business and new substitutes for cash assets, decrease the volume of liquidity available to redeem the debts incurred …In the process of financial expansion the financial system contrary to appearances, becomes progressively illiquid” (Nesvetailova 2007)

• The “supposed immunity to financial risk always turns out to be illusory, and the risks and costs of shattering the illusion may be considerable” (Wojnilower 1980)

Scarcity vs abundance

• Credit is not a scarce resource:

“We may have as much, or as little, credit as we want: credit is created whenever we accept the liabilities of someone who desires more purchasing power” (Wray 1994)

Unfettered vs regulated markets

• “I have said that we fall into two main groups. What is it that makes the cleavage which thus divides us? On the one side are those who believe that the existing economic system is, in the long run, a self-adjusting system, through which creaks and groans and jerks, and interrupted by time lags, outside interferences and mistakes…. On the other side of the gulf are those who reject that idea that the existing economic system is, in any significant sense, self-adjusting. (Keynes speech 1934)

Financialization

Financialization: definition

• “Financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (Epstein 2006)

Financial institutions – stylized facts

• The GDP share of the finance, insurance and real estate sectors has nearly doubled

• The profits of financial corporations relative to those of non-financial corporations have doubled or tripled.

• The profits of banks as a percentage of their total assets have nearly doubled.

• Compensation of employees in the financial sector as a percentage of total compensation in the economy has doubled.

• The turnover rate of shares on stock markets has doubled.

Non-Financial corporations – stylized facts• The percentage of financial assets held by non-financial

corporations relative to tangible assets has tripled, now on par.

• Non-financial corporations, that used to issue new equity to finance their investments, now have been buying back stocks 22 out of the last 25 years.

• Non-financial corporations now raise a larger proportion of their funds through bond issues.

• The interest and dividend income of non-financial corporations as a percentage of their gross value added has trebled.

• The interest payments of non-financial corporations as a percentage of their gross value added has quadrupled.

• The dividend payout ratio (as a percentage of their cash-flow) has doubled.

Distributional issues – stylized facts

• The wage share of income has gone down.• The share of income going to rentiers has risen• Labour hourly productivity has grown much faster than

hourly earnings or even hourly total compensation of production and non-supervisory workers.

• The income share of the lowest quintile has fallen.• The income share of the highest quintile has risen.• There has been an incredible rise in the income share of

the top centile.

Top Decile (10%) Income Share, USA, including capital gains (Saez 2009)

Top .01% Income Share, USA, including capital gains (Saez 2009)

Flow-of-funds – stylized facts

• The net accumulation of financial assets of corporations is positive, meaning that they lend their surpluses to households, with about half of these funds coming from financial corporations.

• The net accumulation of financial assets of households is negative, meaning that they borrow from corporations to pay for their consumption, financial and real estate investments.

• This has been made possible in particular by the use of margin debt – the borrowing of money, collaterized by equity in the stock market or equity in homes.

Fordist regime of accumulation (1950-1975)

• High real wages relative to labour productivity

• Low real rates of interest

• High investment expenditures

• High public infrastructure expenditures

New regime – finance driven

• Low median real wages

• High real interest rates and dividend payments (for most of the period)

• Rising debt to personal income ratios

• High propensities to consume, based on equity in the stock market and real estate

• The regime is not sustainable

Household debt to disposable income ratio, US and Canada

0

20

40

60

80

100

120

140

160

180

200

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Canada United States

debt / PDI

Source:

Effect of a one-time increase in the flow of

gross household loans to personal income

Effect of a one-time increase in the flow of gross household loans to personal income

2009: the worse of two worlds• The real estate market crashed before

these negative effects could really take effect.

• But now we have two negative effects operating at once on consumption:– The long-run negative effects of high

household debt– The short-run negative effects of high saving

rates, directly from higher propensities to save, and indirectly from a lower propensity to take new debt

The boxed-in worker

Corporations

Finance

Globalization Environment

Central bank

Government

The boxing theories

• Global warming

• Comparative advantage (free trade), financial deepening (free capital movements)

• Sound finance

• NAIRU, the neutrality of money

• Shareholder value, agency theory

• Efficient market hypothesis

The corporate and finance lids of the box

• Shareholder value and agency theory (stock options) were supposed to take away the power of corporate managers and give it to small shareholders. Have they?

• Dividends out of profits are higher, but profits have been ransomed by CEOs

• Short-termism: take the money and run!

1/(1+)i1970s

G

R

Growth rate

Profit rate

Expansion frontier

Financefrontier

g1970s

i1990s

g1990s

r1990s

rmin

Shareholder governance with managerial surplus appropriation

Managerialsurplus

{

Securitization

The originate and distribute model of banking

Securitized mortgages as a ratio of total mortgages, US and Canada

Mortgages securitzed as a % of total

0

0.1

0.2

0.3

0.4

0.5

0.6

Mortg Securitized US

Mortg Securitized Canada

Two meanings to securitization

• First kind: bonds tied to the mortgage are issued on the liability side, but the bank keeps the loans on its books.– Often only conforming loans, insured by some

government agency

• Second kind: the loans are removed from the balance sheet of the bank– The bank may even decide to buy back the

securitized asset and take default insurance on it.

Securitization of the first kind

Asset Liability

Loan MBS

Bank

Securitization of the second kind

Assets Liabilities

Bank

Loans -100 Deposits -100

Special Purpose Entity

Loans + 100 MBS + 100

Investor

MBS +100

Deposits -100

The advantages of securitization and its

derivatives, according to finance

• It reduces risk in the banking system

• It makes the payment system immune to insolvency

• It spreads risk to those best able to handle it

• It is a stabilizing factor

• It diversifies the supply of assets

• It reduces the cost of mortgages

The dangers of securitization

• Disconnects the risk of the defaulting borrower from the bank granting the loan.

• Creates a chain of self-serving agents getting bonuses (short-termism again):– Mortgage broker, property appraiser, loan officer,

securitizer, bond rater, lawyer, underwriter, CDS issuer, investment manager.

• With deregulation, more fraud incentives (lender-induced liar loans)

Credit default swaps according to Wojnilower 1984

• “The recent entry of major insurance companies into the business of insuring banks and bond investors against loan defaults represents another effort to stretch the safety net. Now it can be presumed, the authorities will have to intervene to interdict a cascading of defaults only if to save the insurance industry” (Wojnilower 1985, p. 356).

Securitization according to Minsky 1987

• Securitization helps financial globalization• Securitization will lead to credit-enhancing

mathematical techniques (AAA rate at BBB yields)

• There will be “a thin market if price and quality of the securities deteriorate”

• “Securitization implies that there is no limit in creating credits for there is no recourse to bank capital”

Securitization suitable for a global financial structure

GROWTH IN FOREIGN HOLDINGS OF U.S. DOLLAR SECURITIES, 2003-2007*

0

50

100

150

200

250

300

350

400

Asset-backed securities Other Long-term Debt Equities

Average annual growth rate

*June-to-JuneSource: U.S. Treadury Department and TD Economics estimates

Securitization, globalization, and tax heavens

SHARE OF U.S.-DOLLAR ORIGINATED MORTGAGE-BACKED SECURITIES HELD ABROAD*

0 5 10 15 20 25

Remaining nations

Bermuda

China

Jersey

Belgium

Japan

Luxembourg

Germany

Netherlands

UK

Caymen Islands

Percent of total

*As of June 2008Source: Federal Reserve Bank of New York

Securitization of the second kind, and Basel II

Assets Liabilities

Bank

Loans -100 Equity required -8.0

MBS +100 Equity required +1.6

Special Purpose Entity

Loans + 100 MBS + 100

Conclusions

Financial markets blew up on their own

• This is not a true Minsky crisis.• In the Minsky crisis, the problem starts with over-

indebtedness of NF firms, and explodes because of rising interest rates.

• This was not really the case in 2007, and neither was it in 1929.

• Both in 1929 and 2007, problems arose from over-indebtedness of households, and, as in Japan, a meltdown of the real estate market and the equity market.

US non-financial corporation debt to equity ratio

Source: Wachovia Bank

Canadian non-financial corporation debt to equity ratio

Source: Statistics Canada, National Balance Sheet Accounts, 4th qtr 2008

Self-regulation does not work

• One needs tougher regulations on banks• Revamp Basel II, and backtrack towards Basel I• These regulations must be extended to all previously

unregulated financial sectors (off-balance sheets, investment banks, hedge funds, equity funds)

• Pay incentives have to be revamped, perhaps even eliminated

• Securitization of the second kind and CDS may need to be forbidden

• The role of central banks needs to be reconsidered (inflation vs financial stability)

• Fiscal policy must come back to the forefront